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Linear Regression Channel

From The Free Forex Encyclopedia

Linear regression is a statistical tool used to predict the future from past data. It is used to determine when prices are overextended.

A Linear Regression trendline is simply a trendline drawn between two points using the least squares fit method. The trendline is displayed in the exact middle of the prices. If you think of this trendline as the "equilibrium" price, any move above or below the trendline indicates overzealous buyers or sellers.

If you had to guess what a currency pair’s price would be tomorrow, a logical guess would be "close to today's price." If prices are trending up, a better guess might be "close to today's price with an upward bias." Linear regression analysis is the statistical confirmation of these logical assumptions.

A popular method of using the Linear Regression trendline is to construct Linear Regression Channel lines. Developed by Gilbert Raff, the channel is constructed by plotting two parallel, equidistant lines above and below a Linear Regression trendline. The distance between the channel lines to the regression line is two standard-deviations.

Linear regression channels contain price movement, with the bottom channel line providing support and the top channel line providing resistance. Prices may extend outside of the channel for a short period of time. However if prices remain outside the channel for a longer period of time, a reversal in trend may be imminent.

A Linear Regression trendline shows where equilibrium exists. Linear Regression Channels show the range prices can be expected to deviate from a Linear Regression trendline.

The linear regression channel is a tool that is used to help predict the various future values of the item as they compare to the past values of it. To form the linear regression channel, parallel as well as equidistant lines are made. These lines are drawn above as well as below a linear regression trendline. When this is done, the distance that lies between the channel lines and the regression line is the largest distance between any of the closing prices as compared to the regression line.

When using this method, the top channel line provides for resistance while the bottom line provides support. Although prices may extend outside of this channel, it is usually only for a relatively short period of time. If prices stay outside of the channel, then it is possible that a reversal in trend may have been determined. The linear regression channel shows the range in the various prices that are to be expected in comparison to the trendline.